Q No.

1) What is Balance of Payment: Explain the following Components of balance of Payment

in detail

a) Current account transactions

b) Capital account transactions
c) Transactions in official reserve assets of central banks

Ans. The balance of payments of a country records all the transactions that have taken place in a given
period between the country’s residents and the rest of the world.

The basic rule of balance of payments accounting is that transactions that give rise to a receipt from the
rest of the world (such as a U.S. export of Hollywood movies to Pakistan) appear as a positive item (a
credit) and any transaction giving rise to a payment to the rest of the world (such as imports of toys
from China) appears as a negative item (a debit).

International transactions are divided into three major categories:

1. Current account transactions
2. Capital account transactions
3. Transactions in official reserve assets of central banks

1. Current account transactions:

Includes, first, transactions that involve exchanges of goods and services.

It also includes investment income receipts (or payments), because conceptually profits or interest
made on foreign investment could be seen to represent receipts for the services provided by those
investments abroad.

Current Account Balance = Balance of exports and imports of goods, services and investment income
plus unilateral transfers

Finally, this category also includes the value of any gifts, such as foreign aid given by the Country to
foreign governments or private remittances sent to foreign countries by residents, called unilateral
transfers.

2. Capital account transactions

•Involves international purchases or sales of assets, including purchases of bonds or stocks, direct
foreign investments made by companies abroad, etc.
•It excludes any transactions by central banks involving their international reserves (this item is included
in the third category of international transactions,

3. Official International Reserve Assets

This category includes any purchases or sales of international reserve assets.

Examples:
•The State Bank of Pakistan sells euros in the foreign exchange market. This is equivalent to a Pakistan
export of currencies and it appears as a positive item in the U.S. international transactions table.
Q No. 2) Define and explain briefly the following terms

i. Foreign exchange market

The foreign exchange market is the market in which participants are able to buy, sell, exchange and
speculate on currencies. Foreign exchange markets are made up of banks, commercial
companies, central banks, investment management firms, hedge funds, and retail forex brokers and
investors. The forex market is considered the largest financial market in the world.

the PKR point of view and the exchange rate between the PKR and any other currency will be expressed
in terms of the PKR price of the foreign currency. Since the price of $1.00 is Rs. 100, the
exchange rate between the Pak Rupee and
dollar is
e(Rs/$) = PKR 100
The value of a currency is inversely related to its exchange rate.
• Suppose, for example, that the exchange rate increases.
• Since the exchange rate is the price of a foreign currency, an increase in the exchange rate means that
the foreign currency becomes more expensive to buy in terms of domestic currency.
• This means that the value of the domestic currency in terms of that foreign currency decline.
• That is, the domestic currency depreciates in value relative to the foreign currency

ii. Effective exchange rate

A currency may be gaining strength against one currency and losing it against another.
But often we want to know whether a currency’s overall value is appreciating or depreciating.There is an
index that intends to measure overall changes in the value of a currency. This index is called an effective
exchange rate
Note that effective exchange rates are index numbers, expressed in terms of a base year assigned a
value of 100.
• A value of 200 for the PKR index means that the average price of foreign exchange has doubled in
comparison to the base year: overall, the PKR would have depreciated relative to the currencies of its
main trade partners or competitors.

iii. Real exchange rate

The concept of a real exchange rate is intended to align more carefully with the concept of
competitiveness, by adjusting exchange rates by relative prices.
Symbolically, the real exchange rate is defined as:
q = eP*/P
Where:
e is the exchange rate (say in dollars per euro)
P* is the price of foreign goods (say, US goods), and
P is the price of Pakistani goods (in PKR)
An increase in the real exchange rate:
q = eP*/P ↑
Means that the domestic currency has depreciated in value in real terms and domestic goods have
become relatively cheaper compared to foreign goods. So, PAKISTANI price-competitiveness has
increased. A decrease in the real exchange rate:
q = eP*/P ↓
Means that the domestic currency has appreciated in value in real terms and domestic goods have
become relatively more expensive compared to foreign goods. So, Pakistani price-competitiveness has
declined.

iv. Purchasing Power Parity

Purchasing power parity assumes that in some circumstances (for example, as a long-run tendency) it
would cost exactly the same number of, for example, Pak Rupees to buy Dollars and then to use the
proceeds to buy a market basket of goods as it would cost to use those Pak Rupee directly in purchasing
the market basket of goods
According to PPP the exchange rate will adjust over time until the real exchange rate is equal to one, or
when:
q = eP*/P = 1
But remember that
eP* = price of foreign goods in domestic currency,
And
P is the price of domestic goods
So, q = eP*/P =1 when eP* = P, or when prices are the same across countries, when converted to the
same currency. In equilibrium,
P = e P*
or e = P/P*
Where
P is the domestic price level (expressed in PKR if you are in the Pakistan)
e is the exchange rate (say in PKR Per dollars)
P* is the price of foreign goods (expressed in foreign currency, say dollars).
Consider the case of the Pakistan and the U.S.A. Suppose that Pakistan inflation rises relative to U.S.A
inflation.
This raises P/P*
According to the theory of purchasing power parity, the dollar would depreciate in value, i.e., the PKR-
dollar exchange rate would increase (e would rise) so that:
↑↑
e = P/P*

v. Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between
two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the
profit being the difference between the market prices.
Arbitrage provides a mechanism to ensure prices do not deviate substantially from fair value for long
periods of time. With advancements in technology, it has become extremely difficult to profit from
pricing errors in the market. Many traders have computerized trading systems set to monitor
fluctuations in similar financial instruments. Any inefficient pricing setups are usually acted upon quickly,
and the opportunity is often eliminated in a matter of seconds. Arbitrage is a necessary force in the
financial marketplace. To understand more of this concept, read Trading The Odds With Arbitrage.
Law of One Price
The law of one price (LoP) is an economic concept which posits that "a good must sell for the same price
in all locations". This law is derived from the assumption of the inevitable elimination of all arbitrage

The law of one price is in place to prevent investors from taking advantage of a price disparity between
markets in a situation known as arbitrage. If a particular security is available for $10 in Market A but is
selling for the equivalent of $20 in Market B, investors could purchase the security on Market A and
immediately sell it for $20 on Market B, netting a profit without any true risk or shifting of the markets.

As securities from Market A are sold on Market B, prices on both markets shift in accordance with the
changes in supply and demand. Over time, this would lead to a balancing of the two markets, returning
the security to the state held by the law of one price.

In efficient markets, the occurrence of arbitrage opportunities are low, most often caused by an event
causing a sudden shift occurring in one market before the other markets are effected.

vi. Hedgers and Speculators

Hedgers, who are producers, processors, and wholesalers, do not necessarily seek to profit from their
transactions in the futures market, but from their actual business activities in the physical commodity
market. They want to hedge themselves against price fluctuations.
Hedgers reduce their risk by taking an opposite position in the market in what they are trying to hedge.
The ideal situation in hedging would be to cause one effect to cancel out another. For example, assume
that a company specializes in producing jewelry and it has a major contract due in six months, in which
gold is one of the company's main inputs. The company is worried about the volatility of the gold market
and believes that gold prices may increase substantially in the near future. In order to protect itself from
this uncertainty, the company could buy a six-month futures contract in gold. This way, if Gold
experiences a 10% price increase, the futures contract will lock in a price that will offset this gain. As you
can see, although hedgers are protected from any losses, they are also restricted from any gains.
Depending on a company's policies and the type of business it runs, it may choose to hedge against
certain business operations to reduce fluctuations in its profit and protect itself from any downside risk.

A speculator is a trader who approaches the financial markets with the intention to make a profit by
buying low and selling high (or higher), not necessarily in that order
Speculators make bets or guesses on where they believe the market is headed. For example, if
a speculator believes that a stock is overpriced, he or she may short sell the stock and wait for the price
of the stock to decline, at which point he or she will buy back the stock and receive a profit. Speculators
are vulnerable to both the downside and upside of the market; therefore, speculation can be extremely
risky.

viii. Forward Market and Spot Market

A forward market is an over-the-counter marketplace that sets the price of a financial instrument or
asset for future delivery. Forward markets are used for trading a range of instruments, but the term is
primarily used with reference to the foreign exchange market. It can also it can also apply to markets for
securities and interest rates as well as commodities.
While forward contracts, like futures contracts, may be used for both hedging and speculation, there are
some notable differences between the two. Forward contracts can be customized to fit a customer's
requirements, while futures contracts have standardized features in terms of their contract size and
maturity. Forwards are executed between banks or between a bank and a customer; futures are done
on an exchange, which is a party to the transaction. The flexibility of forwards contributes to their
attractiveness in the foreign exchange market

The spot is a market for financial instruments such as commodities and securities which are traded
immediately or on the spot. In spot markets, spot trades are made with spot prices. Unlike
the futures market, orders made in the spot market are settled instantly. Spot markets can be organized
markets or exchanges or over-the-counter (OTC) markets.

the spot market is also referred to as the “physical market” or the “cash market” because of the instant
and immediate pace and movement of orders made as orders are made at current market prices.
Market prices are unlike forward prices, which cover prices at a later date

In some cases, crude oil, for example, futures market goods are sold at spot prices. However,
the physical delivery of the goods happens on a later date.

ix. Forward premium and Forward discount

A forward premium occurs when dealing with foreign exchange (FX); it is a situation where the
spot futures exchange rate, with respect to the domestic currency, is trading at a higher spot exchange
rate then it is currently. A forward premium is frequently measured as the difference between the
current spot rate and the forward rate, but any expected future exchange rate suffices.
It is a reasonable assumption to make that the future spot rate will be equal to the current futures rate.
According to the forward expectation's theory of exchange rates, the current spot futures rate will be
the future spot rate. This theory is routed in empirical studies and is a reasonable assumption to make
over a long-term time horizon.

A forward discount, in a foreign exchange situation, is where the domestic current spot exchange
rate is trading at a higher level then the current domestic futures spot rate for a maturity period. A
forward discount is an indication by the market that the current domestic exchange rate is going to
depreciate in value against another currency.

A forward discount means the market expects the domestic currency to depreciate against another
currency, but that is not to say that will happen. Although the forward expectation's theory of exchange
rates states this is the case, the theory does not always hold.

What central banks do? Explain at least 5 Functions of Central Banks?

Activities of Central Banks (depends on the specific institution):
1. Issuing national currency and managing monetary affairs in a country in order to maintain
macroeconomic stability (which may include price stability, output stability, and/or financial
stability).
 Some central banks have very specific missions, such as price stability or controlling inflation.
Others (such as the Federal Reserve Bank in the US) have a much more flexible mission, which includes
economic stability (countering recessions and unemployment).
2. Managing a country’s foreign exchange reserves and (most of the time) intervening in foreign
exchange markets to set or influence exchange rates vis-à-vis other currencies.
We will see later the various ways a central bank intervenes in foreign exchange markets.
3. Serving as a banker to the government, providing financing for budget deficits.
They usually do this by purchasing government debt.
State Bank Of Pakistan have provided loan to govt. in the past but now gradually they are moving
towards zero financing to Govt.
4. Regulating and Supervising the Domestic Banking System (of the overall financial system)
5. Ensuring that checks, electronic and other payments mechanisms in the economy clear quickly
and smoothly. Most central banks, including both the Federal Reserve (Fed) and the European
Central Bank (ECB) have or have had check-clearing systems that they sell at low cost to the
private financial sector.
6. Lending to domestic banking institutions, providing short-term loans to private banks.